While the S&P 500 (SPY) is up 1.5% YTD at the time of writing, bonds are doing much better. Long-term Treasuries (TLT) are doing the best with 10% growth, while corporate debt is flatter (JNK is up 1.6%) and municipal debt has more muted growth (MUNI is up 2.2%). The cumulative annualized total return of the lower-quality bonds pushes things up quite a bit (7.4% for JNK and 4.3% for MUNI), while actively managed bond funds are doing much better after 2013 was an absolute slaughter (PFL, for instance, is up 6.4% YTD with an annual yield of almost 9% even at current prices).
This demonstrates the importance of having asset rotations on macro trends be a part of your overall investment strategy at the portfolio level, but there is more in the world than bonds and stocks, with plenty of asset classes sitting somewhere awkwardly in-between the two.
One such group is the “Business Development Company,” or BDC as it’s commonly known, a middle-market type of company that often invests in smaller companies in the form of direct loans at high interest rates.
An appeal of these companies is that they are required to pay out at least 90% of their earnings to shareholders in the form of dividends, making them a source of income. As a result, some have dividend yields over 10%. A downside of these companies is that they invest in risky businesses, have complicated accounting rules, and higher tax obligations for shareholders than other types of dividends. A bigger downside is that BDCs expand by issuing more shares, which means that your ownership of the company is constantly being diluted.
The share issuance concern is a problem for long-term holding, which is why it is a compelling option for short-term income seekers. Its appeal to income hunters is also another weakness, however; even if the BDC is not itself exposed to rising bond yields, prices in these stocks will fall when the market fears rising yields on Treasuries. To see this in action, just look at UBS’s ETF for the sector (BDCS), which went from 26.91 to 24.95 in a month last year when the “taper tantrum” caused bonds broadly to crater. While the ETF recovered and ended the year near its 2013 high, investors who bought on the tip lost out on the 30% gain in SPY more broadly (not to mention the huge gains in momentum stocks like TSLA and P).
While the opportunity cost for buying BDCs in 2013 is clear, the risk of loss never materialized, which is why BDCs are being looked at differently by institutional investors in 2014. Now the chances of 2014 showing another 30% run for SPY and huge gains in momentum stocks have gone very slim, making income-producing alternatives attractive for a risk-adjusted return.
But the real bull case for this asset class has yet to come, and relates to an administrative quirk; in February and March, both Russell and S&P announced they would drop BDCs from their indices, which accounts for nearly 10% of some BDC holdings. The sell-off would occur throughout the spring and summer, as both companies unwound their holdings.
Already, BDCs are showing the pain. BDCS is down 7.4% for the year, making its diversified yield 7.5%. With this decline, the asset class is beginning to take on the appearance of a distressed asset class and an income provider—a rare and fruitful combination.
This doesn’t mean that investors are pouring into the stocks (which is why they remain cheap). Several concerns remain:
- The Russell Indices have not begun to unwind their BDC holdings, and it’s unclear if S&P is finished unwinding theirs. This could cause prices to fall further in the coming months.
- BDCs are exposed to interest rate risk, and yields on U.S. Treasuries have fallen again to historic lows, with chances that yields could rise in 2015 or later.
- Many individual BDCs have grown substantially and some, like Prospect Capital (PSEC), have been publicly challenged for questionable accounting practices and very un-BDC-like investing strategies.
- While BDCs are exposed to interest rate risk, they are also exposed to macroeconomic risk. A stock sell-off could also result in a BDC sell-off, augmenting the risk for these stocks.
A BDC investment is by no means a slam dunk, and many tradeoffs are involved; however, the unwinding of index holdings provides an unusual opportunity to get distressed assets that are underpriced on a technicality. Anyone who buys a BDC ETF will have limited exposure to this opportunity, but those who do their homework and value individual stocks within this asset class may find underpriced gems that can provide some income—a particularly helpful thing in a time of horizontal markets.